Sunday, 17 November 2013

Two part tariffs: PlayStation4 versus XBox One

Depending on where you live the Sony PlayStation4 is either available or will be soon. Microsoft's Xbox One will follow shortly. Reviewers argue over which is best in terms of graphics, controller and the like, but the general consensus seems to be that they are pretty similar. They are not, however, similar in price! The PlayStation4 is around $100 cheaper than the Xbox. Of course, making like for like comparisons on price is difficult because Microsoft are offering things Sony are not and vice-versa. But, even so it is interesting to explore why Sony might want to come in with a lower price.
      Let's start by supposing Sony has a monopoly - they are the only games console maker. Sony has to set a price to sell the console and a price to sell games. In the parlance of micro theory this is a two part tariff where the console is a fixed cost and the games are a user cost. To make the most money Sony should set the price of games equal to marginal cost and set the price of the console as high as possible. To illustrate, consider the figure below that shows the demand curve of a typical consumer. If the marginal cost of a game is $20 then the games should be sold at $20. That means the consumer will buy 10 games and have a provisional surplus equal to area ABC. This area amounts to $500. Sony, therefore, could charge $499 and extract the entire (less $1) surplus from the consumer. This is the way to maximise profit.

       Now suppose that there are two companies producing an identical product. Selling the console at $499 is unlikely to make much sense any more because Sony's rival can undercut. Ultimately, we would expect the price of the console to be driven down to marginal cost. For example, if the marginal cost of a console is $350 then that's where the price will end up. The average consumer will be $150 better off. Sony and Microsoft only make normal profit (included in marginal cost).
       So, why would it make sense for Sony to charge less than $350? One possibility is to try and recoup money lost on the console by charging more for the games. For example, suppose Sony charges $300 for a console and $40 for games. At a price of $40 the consumer will buy 8 games and have a provisional surplus equal to area CDE. This area amounts to $320. So, if the PlayStation is priced at $300 the consumer is seemingly happy because he gets a $20 surplus. Moreover, Sony is happy because the $50 lost on the console is recouped by the 8x20 = $160 profit from selling the games. Sony is able to make a supernormal profit of $110 per customer.
        The flaw in this plan is whether consumers will go for it. If the PlayStation is priced at $300 and the games at $40 we have seen the consumer gets surplus worth $20. If the Xbox is priced at $350 and the games at $20 the consumer makes surplus $150. The savvy consumer is obviously going to buy the Xbox. Sony's pricing strategy no longer looks so good. Indeed Microsoft could increase the price of the Xbox to $400 and still be the best deal. The key thing to realise here is that: a consumer should value a PlayStation less than the Xbox, even though they are identical products, because it is going to be more expensive to use the PlayStation. The difference in value is equal to area ABDE which is a pretty huge $180.The PlayStation is worth $180 less but only costs (in our example) $50 less.
         But are consumers that savvy? Clearly, the PlayStation looks the better deal if you focus only on the price of the console. My prior, and possibly that of Sony, is that customers will focus on the console price and not pay sufficient attention to the price of games. Basically, the consumer is not going to realise that the high price of the games makes the PlayStation worth less money. If the consumer does not pay enough attention to the price of games then Sony looks a clear winner. They get more customers because of the cheaper console, and they make supernormal profit because of the high price of the games! Not a bad strategy, if it works.